Albert Edwards: "Time Has Run Out"

At the start of his latest note, SocGen's Albert Edwards highlights a recent warning by the Chinese central bank that that financial risks associated with “grey rhino” events - highly obvious yet ignored threats - may surface next year, and reminds readers that going into the 2008 Global Financial Crisis, many of the massive macro imbalances and credit bubbles that ultimately sunk the global economy were all too apparent.

Yet, with his usual gloomy irony, Edwards notes that back then these "grey rhinos" were dismissed as serious threats by mainstream commentators - the same way they are being dismissed now - "in large part because they had been in plain sight for a long time, and yet the global economy had continued to go from strength to strength. Hence naysayers, such as myself – who had correctly identified the extent of the credit bubbles and global imbalances, and hence the likely depth of the coming crisis – were dismissed as stopped clocks (and I still am)."

The SocGen strategist takes this trip down memory lane for two reasons: first to point out that it is not angst about the unknown that gets traders killed - it is complacency about what is obvious to everyone that is the real danger:

I remember being told many years ago on a South African game reserve that the buffalo was the most dangerous of the big five game animals. In large part, this is because of the complacency shown towards them relative to the other, more obviously dangerous big five game animals (ie the lion, leopard, rhino and elephant). It's also a fact that unlike the other big five, the buffalo gives no warning of an imminent charge (see link). It’s complacency that gets you killed, and the same goes for investors with the macro-risks. We all know what the big macro-imbalances are out there, caused by years of loose money, but investors continue to ignore them at their peril.

The second reason is to give the context for his report, in which Edwards shifts away from his usual observation subjects, to focus on what he believes may be two potential epicenters of the next crisis, to wit:

We spend most of our time on these pages focusing on the two biggest threats to the global economy - the US and China, but Japan, the eurozone and UK certainly have glaring macro imbalances and financial bubbles that might burst at any time. The UK probably has one of the worst and most obvious problems, caused by years of easy money, but Brexit has diverted attention from the slump in the saving ratio.

Looking at the collapse in the UK savings rate, a topic he has discussed previously, Edwards writes that despite the slump in savings, the UK economy has actually decelerated substantially below 2%, and while most mainstream market commentators have attributed this weakness to Brexit uncertainty, Edwards believes there is "a far simpler explanation": namely fiscal tightening.

Two years of massive UK public sector fiscal tightening, in both 2016 and 2017, removed some 1¼% from both years' GDP growth (see chart below). Without that savage fiscal tightening, UK GDP would have quite happily skipped along at a 3% rate, well in excess of the eurozone, where the fiscal impulse was neutral. Contrary to what most mainstream economists would have you believe, weak UK GDP had little to do with Brexit uncertainty.

Continuing his criticism of implicit austerity, Edwards notes another way to look at the fiscal tightening is to see it in relation to other sector financial balances. This can be seen from the UK Statistic Office chart below, in which the shrinkage of the public sector deficit (blue bars) has been offset by a swing in the household sector balance from surplus to deficit (yellow bars). Naturally, these sector imbalances must sum to zero for an economy for example if all the domestic sectors in aggregate are borrowers (as they are currently) then the rest of the world will be financing that deficit (ie the purple bar will be above the zero line). And similarly, that purple capital account surplus on the balance of payments is the mirror image of the current account deficit the UK is currently running.

Putting the UK in the context of other nations, Edwards laments that "currently the UK household sector deficit stands head and shoulders above many of the other macro sectoral imbalances that currently exist globally (the German current account surplus is the only other major sector imbalance on a similar scale)."

And, as one would expect, there is a specific culprit for this gaping UK imbalance: the Bank of England: "This debauched UK household sector behavior only occurs because the central bank is too reluctant to remove the monetary punch bowl at the appropriate time."

And since any such imbalance is by definition temporary, its unwind will result in economic devastation:

Sustaining an economic recovery by encouraging extremes of private sector borrowing inevitably ends up with asset bubbles bursting and sharp rises in the savings ratio, causing recession. The UK will be no different. And if (when?) the UK suffers another economic crisis who do you think a disillusioned public will turn to next? Desperate times will call for desperate measures.

Which brings us to the first "buffalo" that needs watching: "while the UK Tory government is congratulating itself on its fiscal rectitude and declaring that public sector austerity is over, the UK household saving ratio is the buffalo we need to watch. But unfortunately, just as in real life, we cannot predict quite when it will charge."

It's not just the UK, unfortunately, that is suffering from similar sectoral imbalances: Edwards writes that a similar heated debate among economists has exploded over the current battle between the Italian government and the European Commission (EC) about Italy's proposed budget expansion.

The orthodox view is that the Italian government is pursuing a ruinous economic policy and an unfolding crisis of confidence will drive up Italian bond yields, threatening contagion and a repeat of the 2011/12 eurozone crisis. Hence the orthodox view is that the newly elected Italian government must sing to the ECs fiscally austere song-sheet.

The SocGen strategist counters that many of the reasons for Italy's low growth problems have nothing to do with being in the euro, and instead focuses on educational attainment and Italy's moribund productivity. He explains:

Italy's membership of the eurozone has got nothing to do with its educational attainment, university enrolment, corporate governance, legal delays, or lastly and most crucially, red tape that binds Italian businesses as tight as an Egyptian mummy.

Italy's position of 51 overall in the World Bank rankings should be a national embarrassment (see chart below, and note Italy is equally ranked 1 in ‘trading across borders’ only because it is in the EU)

In this context, Edwards proposes that the straitjacket of the single currency and hence Italy's inability to devalue "have merely brought these chronic competitive issues to the fore. Indeed none of these problems are new. Yet the Italian economy managed to keep pace with other major industrialised nations quite happily though the 1970s, 1980s and 1990s." And, as Edwards shows, it was not until the 2011 eurozone crisis that Italian GDP began to underperform Germany (see chart below).

This leads Edwards to a disturbing conclusion, namely that "the establishment consensus is engaged in wishful thinking if they believe Italy will ever be able to implement sufficient structural reforms to restore competitiveness (and remember that structural reforms are by their nature often deflationary, and need an expansionary fiscal policy to cushion the initial depressing effects on the economy something the EC would never allow)."

Meanwhile with inferior productivity growth, Italy’s relative real exchange rate rises every year as unit labour costs deviate further and further from the rest of the eurozone (see chart below).

In Edwards' view, without radical measures Italy will likely never ever grow inside the eurozone (Italian GDP is barely above where it was when they joined the euro). Instead, the SocGen strategist is convinced that "Italy will leave the eurozone during the next economic crisis as youth unemployment roars upwards from the current 30% towards 50%, increasing even further the majority support of young Italians to leave the EU (poll conducted by Benenson Strategy Group in October 2017 link.)"

Which goes back full circle to the austerity being imposed upon Italy by the EU: it is this fiscal straitjacket that the Italian government has been forced to wear over the last decade that has become intolerable to the Italian electorate (see chart below showing persistent large primary surpluses) according to Edwards, who notes that "it was only a matter of time before they broke free, but to be honest I am surprised it has taken so long for this confrontation with the EC to occur."

Alberts concludes with some observations on the timing of Europe's inevitable unwind, in which he cites the French finance minister Bruno Le Maire, stating that he fully agrees with the Frenchman's view:

Ambrose Evans-Pritchard of the UK's Daily Telegraph reports that “France has launched a feverish campaign to shore up the euro before the next global downturn, warning that monetary union is not strong enough to withstand another crisis and the euro will face disintegration without fiscal union.

“Bruno Le Maire, the French finance minister, said there are just weeks left for Germany and the Dutch-led "Hanseatic League" to grasp the nettle on long-delayed reforms. “Either we get a eurozone budget or there will eventually be no euro at all,” he said. “If there was a new financial and economic crisis tomorrow, the eurozone could not respond. It is really urgent that we build up the eurozone’s defences. We have been talking for too long,” he told the Handelsblatt newspaper.

“Time is running out before the EU’s make-or-break summit on the future of the euro next month. The global expansion is looking tired and fragile. Mr Le Maire said Europe’s leaders had failed to learn the lessons of 2008 and the 2012 debt crisis. They had not completed the banking union, or broken the ‘bank-sovereign doom loop’ with full help from the bail-out fund (ESM). Nor had they completed the capital markets union, or established a fiscal entity to bind EU economies closer together. “I am not being pessimistic, I am facing reality,” he said.

As noted above, while Edwards "totally agrees" with Bruno Le Maire’s realism, he doesn’t think time is running out, instead "I think time has run out." In keeping with his structural bearishness, Albert claims that "the next global economic downturn is coming and it will throw the eurozone into another major crisis, but one in which Italy will elect politicians committed to leaving the eurozone (actually it might be the same politicians as we have today, but who will feel empowered to show their true anti-euro colours)."

There is one thing Edwards disagrees with: as he says, Bruno Le Maires solution of an EU banking union and fiscal transfers to a perpetually stagnant Italy "is not the answer. These reforms are not throwing down a ladder to help Italy climb out of its hole and escape. Instead it will merely be throwing food down the hole to keep a trapped Italy from fiscal death."

Which brings us to Edwards' gloomy denouement: "make no mistake cometh the crisis, cometh the ECB Central Banker" says Edwards who remembers "the fabulous quote" from Vitas Vasiliauskas, governor of Lithuania's central bank who several years ago claimed that central bankers are magic people!

His quote in full back in May 2016 was “Markets say the ECB is done, their box is empty, but we are magic people. Each time we take something and give to the markets - a rabbit out of the hat.”

They are indeed magic people and a few other things besides. Will it be enough? I doubt it.

Assuming Edwards is correct, where does that leave us? Not surprisingly, in a very gloomy place:

Every major economy is close to falling into a deep hole from which they will struggle to emerge. The monetary and fiscal ladders thrust down into the 2008 pits of despair will no longer be as available next time around. It is difficult to identify who will fall furthest, but of one thing I am sure: the populists that will emerge to ‘save us’ will use fiscal and monetary stimulus in a way that can only be dreamed of. You ain’t seen nothing yet!